Buying (Going Long) Rice Futures to Profit from a Rise in Rice Prices

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Contents

Buying (Going Long) Rice Futures to Profit from a Rise in Rice Prices

If you are bullish on rice, you can profit from a rise in rice price by taking up a long position in the rice futures market. You can do so by buying (going long) one or more rice futures contracts at a futures exchange.

Example: Long Rice Futures Trade

You decide to go long one near-month CBOT Rough Rice Futures contract at the price of USD 13.71 per hundredweight. Since each CBOT Rough Rice Futures contract represents 2000 hundredweights of rice, the value of the futures contract is USD 27,420. However, instead of paying the full value of the contract, you will only be required to deposit an initial margin of USD 2,430 to open the long futures position.

Assuming that a week later, the price of rice rises and correspondingly, the price of rice futures jumps to USD 15.08 per hundredweight. Each contract is now worth USD 30,162. So by selling your futures contract now, you can exit your long position in rice futures with a profit of USD 2,742.

Long Rice Futures Strategy: Buy LOW, Sell HIGH
BUY 2000 hundredweights of rice at USD 13.71/cwt USD 27,420
SELL 2000 hundredweights of rice at USD 15.08/cwt USD 30,162
Profit USD 2,742
Investment (Initial Margin) USD 2,430
Return on Investment 112.84%

Margin Requirements & Leverage

In the examples shown above, although rice prices have moved by only 10%, the ROI generated is 112.84%. This leverage is made possible by the relatively low margin (approximately 8.86%) required to control a large amount of rice represented by each contract.

Leverage is a double edged weapon. The above examples only depict positive scenarios whereby the market is favorable towards you. If the market turn against you, you will be required to top up your account to meet the margin requirements in order for your futures position to remain open.

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Buying Straddles into Earnings

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Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

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Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Hedging Against Rising Rice Prices using Rice Futures

Businesses that need to buy significant quantities of rice can hedge against rising rice price by taking up a position in the rice futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of rice that they will require sometime in the future.

To implement the long hedge, enough rice futures are to be purchased to cover the quantity of rice required by the business operator.

Rice Futures Long Hedge Example

A rice exporter will need to procure 200,000 hundredweights of rice in 3 months’ time. The prevailing spot price for rice is USD 13.71/cwt while the price of rice futures for delivery in 3 months’ time is USD 14.00/cwt. To hedge against a rise in rice price, the rice exporter decided to lock in a future purchase price of USD 14.00/cwt by taking a long position in an appropriate number of CBOT Rough Rice futures contracts. With each CBOT Rough Rice futures contract covering 2000 hundredweights of rice, the rice exporter will be required to go long 100 futures contracts to implement the hedge.

The effect of putting in place the hedge should guarantee that the rice exporter will be able to purchase the 200,000 hundredweights of rice at USD 14.00/cwt for a total amount of USD 2,800,000. Let’s see how this is achieved by looking at scenarios in which the price of rice makes a significant move either upwards or downwards by delivery date.

Scenario #1: Rice Spot Price Rose by 10% to USD 15.08/cwt on Delivery Date

With the increase in rice price to USD 15.08/cwt, the rice exporter will now have to pay USD 3,016,200 for the 200,000 hundredweights of rice. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the rice futures price will have converged with the rice spot price and will be equal to USD 15.08/cwt. As the long futures position was entered at a lower price of USD 14.00/cwt, it will have gained USD 15.08 – USD 14.00 = USD 1.0810 per hundredweight. With 100 contracts covering a total of 200,000 hundredweights of rice, the total gain from the long futures position is USD 216,200.

In the end, the higher purchase price is offset by the gain in the rice futures market, resulting in a net payment amount of USD 3,016,200 – USD 216,200 = USD 2,800,000. This amount is equivalent to the amount payable when buying the 200,000 hundredweights of rice at USD 14.00/cwt.

Scenario #2: Rice Spot Price Fell by 10% to USD 12.34/cwt on Delivery Date

With the spot price having fallen to USD 12.34/cwt, the rice exporter will only need to pay USD 2,467,800 for the rice. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the rice futures price will have converged with the rice spot price and will be equal to USD 12.34/cwt. As the long futures position was entered at USD 14.00/cwt, it will have lost USD 14.00 – USD 12.34 = USD 1.6610 per hundredweight. With 100 contracts covering a total of 200,000 hundredweights, the total loss from the long futures position is USD 332,200

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the rice futures market and the net amount payable will be USD 2,467,800 + USD 332,200 = USD 2,800,000. Once again, this amount is equivalent to buying 200,000 hundredweights of rice at USD 14.00/cwt.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the rice buyer would have been better off without the hedge if the price of the commodity fell.

An alternative way of hedging against rising rice prices while still be able to benefit from a fall in rice price is to buy rice call options.

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Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

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Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

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Rice Trade 2020: 4 Reasons You Might Invest Plus How To Protect Your Portfolio

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Last Updated on March 19, 2020

4 Reasons You Might Invest in Rough Rice

Investors purchase agricultural commodities such as rough rice for a variety of reasons, but the following are most common:

  1. Bet on Global Demand
  2. Climate Change
  3. Inflation Hedge
  4. Portfolio Diversification

Crowds in Asia via Wikimedia

Betting on Global Demand

Demographic trends across the globe bode well for rice consumption. Population growth in Europe and North America is stagnating, but in Africa, the Middle East and Asia, population growth is on the rise.

These regions have traditionally consumed rice as a staple in their diet. As their populations increase, their demand for affordable food sources for their citizens will increase. Rice consumption should benefit from this trend.

Speculating on Climate Change

Rising global temperatures have the potential to wreak havoc on global crop outputs. As more regions experience drought conditions, the potential for food shortages increases. Rough rice prices should benefit.

Drought via pixabay

How Does Rice Act as an Inflation Hedge?

Investing in rough rice is a way to bet on higher inflation. The US Federal Reserve Bank and central banks around the world have kept interest rates low for a long time. These policies are likely to continue since they support consumer borrowing and spending.

Low interest rates have produced speculative bubbles in many assets classes, but not yet in agricultural commodities. Yet food remains the most basic and fundamental necessity. Food commodity prices could see the largest increases if the economy experiences higher inflation. Rough rice prices could benefit from these conditions.

Diversify Your Portfolio

Most traders have the vast majority of their assets in stocks and bonds. Commodities such as rough rice provide traders with a great way to diversify and reduce the overall risk of their portfolios.

Should I Invest in Rough Rice?

Rough rice competes for demand with the other agricultural commodities such as wheat and corn. Consumer preferences for one food staple over another often depend on price. As a result, the prices of many agricultural commodities are correlated with one another.

Therefore, traders wanting to hedge their bets might want to buy a basket of commodities that includes rough rice, other grains, livestock, metals, energy and other staples.

Investing in a basket of commodities that includes rough rice and other commodities can mitigate risk and diversify the composition of assets in a portfolio.

A basket of commodities can also provide protection against inflation and protect a trader from the volatility of movements in individual commodities.

Drought in rice fields via Flickr

Including rough rice in this basket may make sense for the following reasons:

  1. Emerging Market Growth: Africa, Asia and the Middle East have fast-growing countries that will have enormous food needs in the years ahead. These countries have a long history of consuming rice in their diets. As their populations grow, demand for rice may follow suit.
  2. Climate Change: Global warming is a positive catalyst for rough rice prices. Lower crop yields from droughts and excessive heat could boost the price of all agricultural commodities including rough rice.
  3. Weak Dollar: A weak US currency could be beneficial to agricultural commodities including rough rice.

However, traders should also consider the risks of investing in rough rice:

  1. A global economic slowdown could reduce demand for all agricultural commodities including rough rice.
  2. A sustained drop in the price of other agricultural commodities could siphon demand away from rough rice. While usually, such price drops are temporary, there is no guarantee that this will be the case in the future.
  3. Changes in consumer preferences in India and China have the potential to depress demand for rough rice. These countries may adopt more Western dietary norms in the future. This could lead to reduced demand for rice products.

What Do the Experts Think About Rice?

One agricultural economist for the United States Department of Agriculture (USDA) believes that tightening world supplies could produce higher prices in the months and years ahead. He believes that poor weather conditions combined with diminishing global stocks could end the price slide for the commodity:

You can see prices have been dropping, dropping for a while. But now we’re beginning to see tighter supplies in this country and in some other parts of the world.

Dr. Nathan Childs, USDA Economic Research Service

However, Dr. Childs is still cautious. He notes that the excessive inventory buildup will take time to work itself out. In the meantime, there is no shortage of rice:

I look at the all rice ending stocks, and, as I said earlier, we came off three years of abnormally high global ending stocks with high stocks-to-use ratios of 24 percent to 25 percent. That’s too high.

How Can I Invest in Rough Rice?

Investors have a limited number of ways to invest in rough rice:

Rice Trading Methods Compared

Method of Investing Complexity Rating (1 = easy, 5 = hard) Storage Costs? Security Costs? Expiration Dates? Management Costs? Leverage? Regulated Exchange?
Rough Rice Futures 5 N N Y N Y Y
Rough Rice Options 5 N N Y N Y Y
Agricultural ETFs 2 N N N Y N Y
Agribusiness Shares 2 N N N N Y Y
Rough Rice CFDs 3 N N N N Y Y

Rough Rice Futures

The Chicago Mercantile Exchange (CME) offers a futures contract on rough rice that settles into 2,000 hundredweights, or about 91 metric tons of rough rice.
The contract trades globally on the CME Globex electronic trading platform and has expiration months of:

Futures are a derivative instrument through which traders make leveraged bets on commodity prices. If prices decline, traders must deposit additional margin in order to maintain their positions. At expiration, the contracts are physically settled by delivery of rough rice.

Investing in futures requires a high level of sophistication since factors such as storage costs and interest rates affect pricing.

Rough Rice Options on Futures

The CME offers an options contract on rough rice futures. Options are also a derivative instrument that employ leverage to invest in commodities. As with futures, options have an expiration date. However, options also have a strike price, which is the price above which the option finishes in the money.

Options buyers pay a price known as a premium to purchase contracts.

An options bet succeeds only if the price of rough rice futures rises above the strike price by an amount greater than the premium paid for the contract. Therefore, options traders must be right about the size and timing of the move in rough rice futures to profit from their trades.

Rough Rice ETFs

These financial instruments trade as shares on exchanges in the same way that stocks do. There is no ETF that offers pure-play exposure to rough rice prices. The ELEMENTS Rogers International Commodity Agricultural ETN (NYSEARCA:RJA) holds many agricultural commodities, including rice, in its portfolio.

Top 2 Agricultural ETFs/ETNs by Assets Under Management

ETFs such as PowerShares DB Agriculture Fund and UBS ETRACS CMCI Agriculture Total Return ETN invest generally in agricultural commodities , but do not necessarily hold rice in their portfolios.

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Shares of Rough Rice Companies

There are no public companies that offer pure play exposure to rough rice price. However, traders that want exposure may want to consider buying shares in large agribusinesses that provide seeds, fertilizers and pesticides to farmers:

PowerShares DB Agriculture Fund UBS ETRACS CMCI Agriculture Total Return ETN
Company Current Price Description Exchange
Monsanto
Global agricultural company that provides seeds, genomic and other products to farmers. New York
(NYSE) The Mosaic Company Global agricultural company that sells crop nutrients to farmers. New York
(NYSE) Potash Corporation Global agricultural company that sells fertilizer and feed products. New York
(NYSE)

Rough Rice CFDs

One way to invest in rough rice is through the use of a contract for difference (CFD) derivative instrument. CFDs allow traders to speculate on the price of rough rice. The value of a CFD is the difference between the price of rough rice at the time of purchase and its current price.

Some regulated brokers worldwide offer CFDs on rough rice. Customers deposit funds with the broker, which serve as margin. The advantage of CFDs is that trader can have exposure to rough rice prices without having to purchase shares, ETFs, futures or options.

Start Trading Rice

One of the leading CFD brokers for trading agricultural commodities, like rough rice, is Markets.com, here’s why:

  • No commission on trades (other charges may apply)
  • Free demo account
  • Easy to use (mobile-friendly) platform
  • Industry-leading risk management tools
  • Trade aluminium and hundreds of other markets
  • Your funds are safe – publicly listed company regulated by the (FCA) UK’s Financial Conduct Authority, (ASIC) Australian Securities and Investment Commission and the (FSB) Financial Services Board South Africa.

Start Trading at Markets.com Important: Your capital is at risk. CFD services are suitable for experienced traders only.

One of the leading CFD brokers for trading agricultural commodity CFDs, like rough rice, is Markets.com, here’s why:

  • No commission on trades (other charges may apply)
  • Free demo account
  • Easy to use (mobile-friendly) platform
  • Industry-leading risk management tools
  • Trade hundreds of other CFDs
  • Your funds are safe – publicly listed company regulated by the (FCA) UK’s Financial Conduct Authority, (ASIC) Australian Securities and Investment Commission and the (FSB) Financial Services Board South Africa.

Grow Your Finances in the Grain Markets

Temperature, precipitation and the changing needs of customers all contribute to the supply and demand for commodities like wheat, corn or soybeans. All of these changes greatly affect the price of commodities, and the grain markets are essential to managing these price swings and providing global benchmark prices. Read on to dig into and learn about the seven major products of the grain markets. (See also: Futures Fundamentals.)

What Are Grain Futures Contracts?

Anyone looking to invest in futures should know that the risk of loss is substantial. This type of investment is not suitable for everyone. An investor could lose more than originally invested and, therefore, only risk capital should be used. Risk capital is the amount of money that an individual can afford to invest, which, if lost would not affect the investor’s lifestyle.

A grain futures contract is a legally binding agreement for the delivery of grain in the future at an agreed-upon price. The contracts are standardized by a futures exchange as to quantity, quality, time and place of delivery. Only the price is variable.

There are two main market participants in the futures markets: hedgers and speculators. Hedgers use the futures markets for risk management and withstand some risks associated with the price or availability of the actual underlying commodity. Futures transactions and positions have the express purpose of mitigating those risks. Speculators, on the other hand, generally have no use for the commodities in which they trade; they willingly accept the risk involved in investing in futures in return for the prospect of dramatic gains.

Advantages of Futures Contracts

Because they trade at the Chicago Board of Trade (CBOT), futures contracts offer more financial leverage, flexibility and financial integrity than trading the commodities themselves.

Financial leverage is the ability to trade and manage a high market value product with a fraction of the total value. Trading futures contracts is done with performance margin; therefore, it requires considerably less capital than the physical market. Leverage provides speculators a higher risk/higher return investment.

For example, one futures contract for soybeans represents 5,000 bushels of soybeans. Therefore, the dollar value of this contract is 5,000 times the price per bushel. If the market is trading at $5.70 per bushel, the value of the contract is $28,500 ($5.70 x 5,000 bushels). Based on current exchange margin rules, the margin required for one contract of soybeans is only $1,013. So for approximately $1,013, an investor can leverage $28,500 worth of soybeans.

Advantages of Grain Contracts

Because grain is a tangible commodity, the grain market has a number of unique qualities. First, when compared to other complexes like the energies, grains have a lower margin making it easy for speculators to participate. Also, grains generally aren’t one of the bigger contracts (in terms of total dollar amount), which accounts for the lower margins.

The fundamentals in the grains are fairly straightforward: like most tangible commodities, supply and demand will determine the price. Weather factors will also have an effect.

Contract Specifications

There are seven different grain products traded at the Chicago Board of Trade: corn, oats, wheat, soybeans, rice, soybean meal and soybean oil.

Similar grain products trade in other commodities markets around the world, such as Minneapolis, Winnipeg, Hong Kong, Brazil and India to name a few.

1. Corn: Corn is used not only for human consumption but to feed livestock such as cattle and pigs. Also, higher energy prices has led to using corn for ethanol production.

The corn contract is for 5,000 bushels, or roughly 127 metric tons. For example, when corn is trading at $2.50 a bushel, the contract has a value of $12,500 (5,000 bushels x $2.50 = $12,500). A trader that is long $2.50 and sells at $2.60 will make a profit of $500 ($2.60 – $2.50 = 10 cents, 10 cents x 5,000 = $500). Conversely, a trader who is long at $2.50 and sells at $2.40 will lose $500. In other words, every penny difference equals a move up or down of $50.

The pricing unit of corn is in dollars and cents with the minimum tick size of $0.0025, (one-quarter of a cent), which equals $12.50 per contract. Although the market may not trade in smaller units, it most certainly can trade in full cents during “fast” markets.

The most active months for corn delivery are March, May, July, September and December.

Position limits are set by the exchange to ensure orderly markets. A position limit is the maximum number of contracts that a single participant can hold. Hedgers and speculators have different limits. Corn has a maximum daily price movement.

Corn traditionally will have more volume than any other grain market. Also, it will be less volatile than beans and wheat.

2. Oats: Oats are not only used to feed livestock and humans, but are also used in the production of many industrial products like solvents and plastics.

An oats contract, like corn, wheat and soybeans, is for the delivery of 5,000 bushels. It moves in the same $50/penny increments as corn. For example, if a trader is long oats at $1.40 and sells at $1.45, he or she would make 5 cents per bushel, or $250 per contract ($1.45 – $1.40 = 5 cents, 5 cents x 5,000 = $250). Oats also trades in quarter-cent increments.

Oats for delivery are traded March, May, July, September and December, like corn. Also like corn, oats futures have position limits.

Oats is a difficult market to trade because it has less daily volume than any other market in the grain complex. Also its daily range is fairly small.

3. Wheat: Not only is wheat used for animal feed, but also in the production of flour for breads, pastas and more.

A wheat contract is for delivery of 5,000 bushels of wheat. Wheat is traded in dollars and cents and has a tick size of a quarter cent ($0.0025), like many of the other products traded at the CBOT. A one-tick price movement will cause a change of $12.50 in the contract.

The most active months for delivery of wheat, according to volume and open interest, are March, May, July, September and December. Position limits also apply to wheat.

Next to soybeans, wheat is a fairly volatile market with big daily ranges. Because it is so widely used, there can be huge daily swings. In fact, it is not uncommon to have one piece of news move this market limit up or down in a hurry.

4. Soybeans: Soybeans are the most popular oilseed product with an almost limitless range of uses, ranging from food to industrial products.

The soybean contract, like wheat, oats and corn, is also traded in the 5,000 bushel contract size. It trades in dollar and cents, like corn and wheat, but is usually the most volatile of all the contracts. The tick size is one-quarter of a cent (or $12.50).

The most active months for soybeans are January, March, May, July, August, September and November.

Position limits apply here as well.

Beans have the widest range of any of the markets in the grain room. Also, it will generally be $2 to $3 more per bushel than wheat or corn.

5. Soybean Oil: Besides being the most widely used edible oil in the United States, soybean oil has uses in the bio-diesel industry that are becoming increasingly important.

The bean oil contract is for 60,000 pounds, which is different from the rest of the grain contracts. Bean oil also trades in cents per pound. For example, let’s say that bean oil is trading at 25 cents per pound. That gives a total value for the contract of $15,000 (0.25 x 60,000 = $15,000). Suppose that you go long at $0.2500 and sell at $0.2650; this means that you have made $900 ($0.2650 – 25 cents = $0.015 profit, $0.015 x 60,000 = $900). If the market had gone down $0.015 to .2350, you would lose $900.

The minimum price fluctuation for bean oil is $0.0001, or one one-hundredth of a cent, which equals $6 per contract.

The most active months for delivery are January, March, May, July, August, September, October and December.

Position limits are enforced for this market as well.

6. Soymeal: Soymeal is used in a number of products, including baby food, beer and noodles. It is the dominant protein in animal feed.

The meal contract is for 100 short tons, or 91 metric tons. Soymeal is traded in dollars and cents. For example, the dollar value of one contract of soymeal, when trading at $165 per ton, is $16,500 ($165 x 100 tons = $16,500).

The tick size for soymeal is 10 cents, or $10 per tick. For example, if the current market price is $165.60 and the market moves to $166, that would equal a move of $400 per contract ($166 – $165.60 = 40 cents, 40 cents x 100 = $400).

Soymeal is delivered on January, March, May, July, August, September, October and December.

Soymeal contracts also have position limits.

7. Rice: Not only is rice used in foods, but also in fuels, fertilizers, packing material and snacks. More specifically, this contract deals with long-grain rough rice.

The rice contract is 2,000 hundred weight (cwt). Rice is also traded in dollars and cents. For example, if rice is trading at $10/cwt, the total dollar value of the contract would be $20,000 ($10 x 2,000 = $20,000).

The minimum tick size for rice is $0.005 (one half of a cent) per hundred weight, or $10 per contract. For example, if the market was trading at $10.05/cwt and it moved to $9.95/cwt, this represents a change of $200 (10.05 – 9.95 = 10 cents, 10 cents x 2,000 cwt = $200).

Rice is delivered in January, March, May, July, September and November. Position limits apply in rice as well.

Centralized Marketplace

The primary function of any commodity futures market is to provide a centralized marketplace for those who have an interest in buying or selling physical commodities at some time in the future. There are a lot of hedgers in the grains markets due to the many different producers and consumers of these products. These include, but are not limited to, soybean crushers, food processors, grain and oil seed producers, livestock producers, grain elevators and merchandisers.

Using Futures and Basis to Hedge

The main premise upon which hedgers rely is that although the movement in cash prices and futures market prices may not be exactly identical, it can be close enough that hedgers can lessen their risk by taking an opposite position in the futures markets. By taking an opposite position, gains in one market can offset losses in another. This way, hedgers are able to set price levels for cash market transactions that will take place several months down the line.

For example, let’s consider a soybean farmer. While the soybean crop is in the ground in the spring, the farmer is looking to sell his crop in October after the harvest. In market lingo, the farmer is long a cash market position. The farmer’s fear is that prices will go down before he can sell his soybean crop. In order to offset losses from a possible decline in prices, the farmer will sell a corresponding number of bushels in the futures market now and will buy them back later when it is time to sell the crop in the cash market. Any losses resulting from a decline in the cash market price can be partially offset by a gain from the short in the futures market. This is known as a short hedge.

Food processors, grain importers and other buyers of grain products would initiate a long hedge to protect themselves from rising grain prices. Because they will be buying the product, they are short a cash market position. In other words, they would buy futures contracts to protect themselves from rising cash prices.

Usually there will be a slight difference between the cash prices and the futures prices. This is due to variables such as freight, handling, storage, transport and the quality of the product as well as the local supply and demand factors. This price difference between cash and futures prices is known as basis. The main consideration for hedgers concerning basis is whether it will become stronger or weaken. The final outcome of a hedge can depend on basis. Most hedgers will take historical basis data into consideration as well as current market expectations.

The Bottom Line

In general, hedging with futures can help the future buyer or seller of a commodity because it can help protect them from adverse price movements. Hedging with futures can help to determine an approximate price range months in advance of the actual physical purchase or sale. This is possible because cash and futures markets tend to move in tandem, and gains in one market tend to offset losses in another.

How to Use Commodity Futures to Hedge

Futures are the most popular asset class used for hedging. Strictly speaking, investment risk can never be completely eliminated, but its impacts can be mitigated or passed on. Hedging through future agreements between two parties has been in existence for decades.

Farmers and consumers used to mutually agree on the price of staples like rice and wheat for a future transaction date. Soft commodities like coffee are known to have standard exchange-traded contracts dating back to 1882.

Key Takeaways

  • Hedging is a way to reduce risk exposure by taking an offsetting position in a closely related product or security.
  • In the world of commodities, both consumers and producers of them can use futures contracts to hedge.
  • Hedging with futures effectively locks in the price of a commodity today, even if it will actually be bought or sold in physical form in the future.

Hedging Commodities

Let’s look at some basic examples of the futures market, as well as the return prospects and risks.

For simplicity’s sake, we assume one unit of the commodity, which can be a bushel of corn, a liter of orange juice, or a ton of sugar. Let’s look at a farmer who expects one unit of soybean to be ready for sale in six months’ time. Assume that the current spot price of soybeans is $10 per unit. After considering plantation costs and expected profits, he wants the minimum sale price to be $10.10 per unit, once his crop is ready. The farmer is concerned that oversupply or other uncontrollable factors might lead to price declines in the future, which would leave him with a loss.

Here are the parameters:

  • Price protection is expected by the farmer (minimum $10.10).
  • Protection is needed for a specified period of time (six months).
  • Quantity is fixed: the farmer knows that he will produce one unit of soybean during the stated time period.
  • His aim is to hedge (eliminate the risk/loss), not speculate.

Futures contracts, by their specifications, fit the above parameters:

  • They can be bought or sold today for fixing a future price.
  • They are for a specified period of time, after which they expire.
  • The quantity of the futures contract is fixed.
  • They offer hedging.

Assume a futures contract on one unit of soybean with six months to expiry is available today for $10.10. The farmer can sell this futures contract (short sell) to gain the required protection (locking in the sale price).

How This Works: Producer Hedge

If the price of soybeans shoots up to say $13 in six months, the farmer will incur a loss of $2.90 (sell price-buy price = $10.10-$13.00) on the futures contract. He will be able to sell his actual crop produce at the market rate of $13, which will lead to a net sale price of $13 – $2.90 = $10.10.

If the price of soybeans remains at $10, the farmer will benefit from the futures contract ($10.10 – $10 = $0.10). He will sell his soybeans at $10, leaving his net sale price at $10 + $0.10 = $10.10

If the price declines to $7.50, the farmer will benefit from the futures contract ($10.10 – $7.50 = $2.60). He will sell his crop produce at $7.50, making his net sale price $10.10 ($7.50 + $2.60).

In all three cases, the farmer is able to shield his desired sale price by using futures contracts. The actual crop produce is sold at available market rates, but the fluctuation in prices is eliminated by the futures contract.

Hedging is not without costs and risks. Assume that in the first above-mentioned case, the price reaches $13, but the farmer did not take a futures contract. He would have benefited by selling at a higher price of $13. Because of futures position, he lost an extra $2.90. On the other hand, the situation could have been worse for him the third case, when he was selling at $7.50. Without futures, he would have suffered a loss. But in all cases, he is able to achieve the desired hedge.

How This Works: Consumer Hedge

Now assume a soybean oil manufacturer who needs one unit of soybean in six months’ time. He is worried that soybean prices may shoot up in the near future. He can buy (go long) the same soybean future contract to lock the buy price at his desired level of around $10, say $10.10.

If the price of soybean shoots up to say $13, the futures buyer will profit by $2.90 (sell price-buy price = $13 – $10.10) on the futures contract. He will buy the required soybean at the market price of $13, which will lead to a net buy price of -$13 + $2.90 = -$10.10 (negative indicates net outflow for buying).

If the price of soybeans remains at $10, the buyer will lose on the futures contract ($10 – $10.10 = -$0.10). He will buy the required soybean at $10, taking his net buy price to -$10 – $0.10 = -$10.10

If the price declines to $7.50, the buyer will lose on the futures contract ($7.50 – $10.10 = -$2.60). He will buy required soybean at the market price of $7.50, taking his net buy price to -$7.50 – $2.60 = -$10.10.

In all three cases, the soybean oil manufacturer is able to get his desired buy price, by using a futures contract. Effectively, the actual crop produce is bought at available market rates. The fluctuation in prices is mitigated by the futures contract.

Risks

Using the same futures contract at the same price, quantity, and expiry, the hedging requirements for both the soybean farmer (producer) and the soybean oil manufacturer (consumer) are met. Both were able to secure their desired price to buy or sell the commodity in the future. The risk did not pass anywhere but was mitigated—one was losing on higher profit potential at the expense of the other.

Both parties can mutually agree with this set of defined parameters, leading to a contract to be honored in the future (constituting a forward contract). The futures exchange matches the buyer or seller, enabling price discovery and standardization of contracts while taking away counter-party default risk, which is prominent in mutual forward contracts.

Challenges to Hedging

While hedging is encouraged, it does come with its own set of unique challenges and considerations. Some of the most common include the following:

  • Margin money is required to be deposited, which may not be readily available. Margin calls may also be required if the price in the futures market moves against you, even if you own the physical commodity.
  • There may be daily mark-to-market requirements.
  • Using futures takes away the higher profit potential in some cases (as cited above). It can lead to different perceptions in cases of large organizations, especially the ones having multiple owners or those listed on stock exchanges. For example, shareholders of a sugar company may be expecting higher profits due to an increase in sugar prices last quarter but may be disappointed when the announced quarterly results indicate that profits were nullified due to hedging positions.
  • Contract size and specifications may not always perfectly fit the required hedging coverage. For example, one contract of arabica coffee “C” futures covers 37,500 pounds of coffee and may be too large or disproportionate to fit the hedging requirements of a producer/consumer. Small-sized mini-contracts, if available, might be explored in this case.
  • Standard available futures contracts might not always match the physical commodity specifications, which could lead to hedging discrepancies. A farmer growing a different variant of coffee may not find a futures contract covering his quality, forcing him to take only available robusta or arabica contracts. At the time of expiry, his actual sale price may be different than the hedge available from the robusta or arabica contracts.
  • If the futures market is not efficient and not well regulated, speculators can dominate and impact the futures prices drastically, leading to price discrepancies at entry and exit (expiration), which undo the hedge.

The Bottom Line

With new asset classes opening up through local, national, and international exchanges, hedging is now possible for anything and everything. Commodity options are an alternative to futures that can be used for hedging. Care should be taken when assessing hedging securities to ensure they meet your needs. Bear in mind that hedgers should not get enticed by speculative gains. When hedging, careful consideration and focus can achieve the desired results.

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